EU Can Only Make the Best of Its Terrible Choices

May 8 (Bloomberg) -- The European Central Bank has deployed
almost the last of its depleted supply of conventional monetary
stimulus, cutting its benchmark interest rate last week to 0.5
percent from 0.75 percent. Few expect this to make much
difference to Europe’s flailing economy, and financial markets
were unmoved. If conventional monetary policy is all but used
up, what else is there?

Hans-Werner Sinn, head of Germany’s Ifo Institute for
Economic Research, gave a bleak answer in a recent talk at the
Peterson Institute for International Economics in Washington.

He said the crux of the challenge was the competitiveness
gap between Greece, Portugal, Spain and the other troubled
economies on one side and Germany and its successful neighbors
on the other. The European Union’s problem isn’t that its
economy as a whole is struggling, but that some countries are
doing so much worse than others. This divergence calls for
policies aimed at particular countries. Thanks to the single
currency, orthodox monetary policy can’t play that role.

The choices, he said, boil down to three. First, presumably
by resorting to unconventional stimulus -- such as quantitative
easing -- the ECB could try to raise prices in the core
countries faster than in the periphery. That won’t happen
because Germany won’t stand for it. Second, Greece and the
others could let the combination of very high unemployment and
structural economic reform slowly grind down wages and prices.
That will be impossibly painful, he believes. Third, there could
be exits -- possibly temporary ones -- from the euro system.
That would close the competitiveness gap by allowing for
devaluations; on the other hand, the short-term costs of exits
are severe.

Terrible Options

All the possibilities are bad, Sinn said: “The solution set
is in a sense empty for the euro zone.” All that can be done is
to muddle through using a mixture of all three terrible options.
Brutal adjustment in the periphery (plus debt restructurings
that bail in investors, Cyprus-style). A pinch of above-target
inflation in Germany and the rest of the core. Temporary exits
from the euro area for the worst cases. That’s what Sinn expects
and, indeed, recommends.

There’s a fourth option -- one that Sinn disapproves of so
intensely he could hardly bring himself to mention it. That’s
overt fiscal transfers, in one form or another, from strong
economies to weak, to help ease the pain of adjustment. Such
transfers supplant private investment decisions with political
investment decisions, he said. It would be the end of Europe’s
capitalist market economy. “I think it would be a disaster,” he
said.

If you ask me, that’s ridiculous. In a situation that
requires choosing the least painful mix of policies from some
very unpalatable options, a degree of fiscal risk-pooling --
say, through the creation of conditional euro bonds -- ought to
be part of the remedy. And it eventually will be, I’m willing to
bet, because Germany and the core will come to see it’s in their
best interests. (When the choice is between fiscal transfers and
debt bail-ins for Germany’s undercapitalized banks, see what
happens.) But Sinn is right that there will be no coherent
strategy. That’s never how the EU does things.

He’s right, too, that narrowing the price-and-labor-cost
gap between core and periphery is crucial. The ECB can’t act
directly on that. In a way, it’s irrelevant to the main problem.
The question is what national governments such as Greece, Italy
and Spain can do to ease the process.

Internal Devaluation

What’s needed is internal devaluation. An ordinary
devaluation works by raising import prices, which reduces real
wages. Living standards fall, but so do relative labor costs,
which helps restore growth. Internal devaluation -- that is,
“devaluation” with the exchange rate fixed -- has to reduce
relative labor costs in some other way. One possibility is tax
reform. Raise sales taxes while cutting payroll taxes, for
instance. This has already been done in several countries,
though on a timid scale.

Then there’s high unemployment, which eventually drives
down wages -- or ought to. The signature problem of countries
such as Greece and Spain is that extremely high unemployment has
had so little effect on labor costs. That’s the sign of a broken
labor market and a promise of prolonged economic agony. But
internal devaluation has worked better in Ireland, for instance,
which has now closed much of its competitiveness gap. Germany,
as Sinn noted, achieved internal devaluation after its labor
costs got out of line during the previous decade. This was done
partly through wage moderation caused by reforms to its
unemployment insurance system.

One approach I’m surprised hasn’t aroused more discussion
is “incomes policy” -- mandatory or quasi-mandatory cuts in
wages. This method of curbing inflation was popular in many
countries during the 1970s, then fell into disuse. As you might
expect, the countries that tried it found it ill-suited to
curbing chronic inflation, because evasion, distortions and
anomalies built up over time. It’s more promising as a way to
cut labor costs abruptly and by a lot. Before you dismiss the
idea, consider the relevant alternatives -- a cruelly extended
spell of high unemployment or a conventional devaluation with
the huge additional costs that would attend an exit from the
euro system.

Despite reports to the contrary, internal devaluation can
work. Ireland has shown that and so, oddly enough, has Germany.
For Europe’s sake, it must be made to work in Greece and the
other struggling economies -- not as the only treatment, but
alongside fiscal transfers and other measures. To work, internal
devaluation has to hurt. Whether the pain is bearable or
unbearable depends on how it’s done.

(Clive Crook is a Bloomberg View columnist. The opinions
expressed are his own.)